How to create an all weather portfolio for yourself

Portfolio | Published on 12th February 2019 | 718

What exactly is an all weather portfolio? Obviously, it is not a portfolio that will outperform under all conditions. That does not exist in reality. An all weather portfolio which has an element of alpha and risk management built into it. That means in good times the portfolio does not really perform better than an aggressive portfolio. On the contrary, it ensures that the portfolio performs better than the benchmark index. But the more important aspect of an all-weather portfolio is that it does better than the index in a falling market. You don’t
really compare an all-weather portfolio to a short fund on the downside, but it does better than the index (falls less). What this means is that over a period of time as cycles get evened out, the all-weather portfolio does better than the index by a margin. But more importantly, it is a portfolio that carries lesser risk than a pure alpha portfolio.

An all-weather portfolio is, therefore, designed to manage the risk as you create wealth in the long term. There are occasions when equities will perform better and there are times when debt will perform better. Let us also compare the merits of an all weather portfolio vs a pure alpha portfolio. Here is how you can go about creating an all-weather portfolio.

1. Most of your risk can be managed through diversification

Irrespective of the asset class that you invest in, there is risk involved. Let us look at some key asset classes. Equity carries market risk and debt has interest rate risk. Even a portfolio of commodities is vulnerable to price risk and cyclical risk. There is a lot of merit in diversification. For example, equities and gold typically enjoy a negative correlation. That means gold tends to perform better when equities are underperforming. So if you add a
small portion of gold to your portfolio, it can become a good hedge in tough times. That is how diversification becomes useful. Creating an all-weather portfolio begins with diversifying your risk across asset classes to capitalize on more economic probabilities. The beauty is that you can assign subjective probabilities to various asset classes and tweak your asset mix accordingly.

2. Alternatively you opt for balanced funds or dynamic funds

A Balanced fund typically mixes debt and equity to give a flavour of wealth creation and stable income. These balanced funds have an in-built all-weather flavour to them. It is not just a plain vanilla product. Within balanced funds, you can choose between equity balanced funds and MIPs and you can also opt for FMPs if you are willing to get locked into a closed ended fund. You may complain that these balanced funds still leave you with a problem of choice as you are unable to decide whether you want equities to predominate or debt. The option could be dynamic funds, where the fund manager will do this job for you.

Here is how a dynamic fund will work. Your fund can base this dynamic on transparent rules. For example if the index P/E goes above threshold then you automatically reduce your equity exposure and if the P/E goes below a certain threshold then you increase equity exposure. You can have similar rules for debt too. For example, if rates are looking dovish then let long dated debt predominate your portfolio and you can shift to floating rate funds or liquid funds where the interest rate risk rises with a rise in yields. You can also set similar rules for gold and other commodities. Dynamic can be a good form of actively managed asset allocation, provided it is done by an expert fund manager.

3. Gold and commodities are solid hedges to your portfolio

You obviously cannot consider gold as a full-fledged investment class. But it does have a role to play in hedging your risk. Therefore an allocation of 10-15% of your portfolio to gold is advisable and you can tweak this range based on the level of volatility in equity markets. It is an inverse relationship between equity volatility and gold prices. Even within gold as an asset class you have a wide choice of instruments. Instead of physical gold, you can prefer the more convenient gold bonds or gold ETFs. They are virtual proxies for physical gold.
Gold automatically outperforms in turbulent market conditions and thus gives you a hedge against negative returns on asset classes like equity and debt. Gold has been uncorrelated with traditional assets like equity and that is a genuine advantage.

We shall not spend too much time on other commodities as they are yet to emerge as a distinct class in India. The reason they are important is that industrial commodities follow a longer down cycle and up cycle and hence they are a lot more predictable. Of course, you can invest in commodities through commodity stocks or through global commodity funds. Global commodity funds are a good method as they represent raw commodities.

4. Finally, systematic investing works as an all-weather strategy

Whether you are buying equities or equity funds; phased investing works best. It is passive and you don’t have to worry about timing the peaks and troughs of the market. When you adopt a phased approach, the concept of rupee cost averaging works in your favour and over time your average cost ends up lower. This is helpful in all market conditions.

The moral of the story is that creating an all-weather portfolio is nothing like rocket science. Get the four pillars of diversification, low correlation, dynamic allocation and phased approach in place. The rest of the story will follow logically!